How To Make Debts Disappear? (2024)

Economic progress in Asia was built by credit, and a lot of that debt happened to end up in unprofitable banks and companies.

To “vaporize” bad debt, governments use capital controls to influence the difference between interest rates. But as the saying goes: “Rules are made to be broken”, meaning the already high-tensioned financial system further weakens, and how we invest in the region’s largest economy changes forever.

China the Debt Exterminator

We wrote about how China and other Asian countries, “remove” non-performing loans (NPLs) via wide interest margins to clean up its debt-laden system.

The upside of wide interest rate margins is that banks are more likely to make huge profits.

For example, if there’s a 5 percent lending rate and a 2 percent deposit rate, then the margin is 3 percent. This difference between is the source of profit for banks.

This margin also helps cover NPL-derived losses.

In the 1990s, the Chinese government started using this “tactic” to “exterminate” lethargic companies that lose cash and default on loans regularly.

Zhu Rongji (China’s then Premier) focused heavily of getting rid of “zombie” companies. His policies included closing down failing companies and broadening interest rate margins - the gap between lending and deposit rates, which ensured that banks could slowly service bad debt.

Like what the graph below shows, interest rate margins in emerging Asian markets are much wider compared to the rest of the world.

In countries like Vietnam, the margin can be over 5 percent, so that the government can fund huge development projects that have lots of NPLs.

What created this?

How handy are capital controls?

Capital controls exist in multiple Asian nations, particularly developing countries. Taxes, reduction or elimination of a country’s capital inflows and outflows are all capital control.

Basically, the point is to limit an economy’s flow and its amount of money.

The restriction of supply, in addition to unchanged or higher demand, leads to price increase.

In the case of capital controls, when the lending rate is raised (which increases the “cost” of borrowing) while not affecting the deposit rate, then banks can write off more loans since interest rate margin becomes larger.

Going back to the example above: 5 percent lending rate and 2 percent deposit rate adds up to a 3 percent margin. Let’s say suddenly there’s capital controls in the market, where lending rate is increased to 6 percent, then there’ll be a 4 percent margin. Although a 1 percent increase may seem small, understand that this applies to loans that are worth billions of dollars, so small changes can lead to drastic outcomes.

Closed market systems is typically where this model works best. However, China’s capital controls dropped (a process called market liberalization) after it joined the WTO in 2001.

What’s left of China’s capital controls isn’t that stable. Every year, around 8 percent of China’s GDP comes and goes without the country’s approval.

Capital controls are not meant to be “airtight”, but rather gives more market control to developing countries. Regardless, these countries prefer moving money in this way, rather than tolerating the free market.

When people outsmart the rules

People will eventually figure out a way to get around this form offinancial repression, so the use of capital controls can be quite limited.

Even commercial banks cheat this system to gain higher margins. Several firms redirect cheap credit from low-return development projects to real estate and other high-margin activities.

A typical citizen can find ways to increase their savings’ returns by storing their wealth somewhere other than banks.

Because capital controls are “penetrable”, individuals, firms and banks will always try to move around long-term government development goals in order to gain short-term profit.

Therefore, no country (including China) can utilize financial control forever. But what matters is how quickly they can write off enough NPLs.

Ramifications

China cannot maintain its ability to “vaporize” debt, since the effectiveness of wide interest rate margins will lessen over time.

Recently, to counteract this issue, Chinese authorities are taking a break from restraining control of capital in credit markets and shadow banking. The goal for “financial stability” is no longer debt control.

Even though capitals controls still exist, the government has lately been dismantling them one by one. For example, even though the central bank still dictates base interest rates, bank deposit and lending rates are totally liberalized now.

Since May 2015, a bank deposit insurance program is supposed to somewhat control the banking sector. Meanwhile, there’s also an improved resolution mechanism that assist failing banks. Whether these solutions eliminate China’s NPLs is only a matter of time.

Expectations

Because China’s role in the international financial system is becoming more crucial, capital liberalization is unavoidable.

Wide interest rate margins will definitely shrink as capital controls change. That’s good news for finance consumers and entrepreneurs who are looking to borrow money and build businesses.

Lower interest margins also help construction, real estate companies and other firms that depend on high amounts of debt to finance operating activities.

We at One Road Publishing will always update you on any changes that can affect how you invest in the largest economy in Asia.